Your business is like a child you have nurtured for a long-time, and it’s time to test your child. In simple words, your business is your primary asset, and valuing your business means to determine the economic value of your business. Evaluating your business is pure mathematics, but when to use these mathematics to sell, this business is purely artistic.
Valuing your business is a convoluted procedure that relies mainly on the finances of your business. Such complexity requires a professional business evaluator to help with crunching those numbers and evaluate your business’ worth. However, it is critical to understand how the procedure works, and here is an in-depth discussion on how you value your business.
In this Article:
- You will understand what business valuation is and why it is needed.
- Different types of business valuation methods will be discussed.
- Crucial steps that will help you evaluate your business
- What are the key statistics to the challenges that you will face in an inefficient exit strategy?
What is Business Valuation?
Business valuation means to estimate the economic worth of your business. The methods of business valuation take a holistic approach to value each aspect of your business. For example, anything has an economic value such as inventory, property, liquid assets, or equipment. Even factors such as management structure, revenue, share price, and projected earnings are considered.
Moreover, business valuation is essential for tax reporting. The IRS requires a business to be valued at the market price. Depending on the valuation of your company, selling a part of your company, purchase, or gifting shares of a company will be taxed accordingly.
Why is Business Valuation Needed?
As mentioned before, valuation is required by the IRS for taxation. For more guidelines on a business valuation by IRS, visit this page. However, there are many other reasons why you need a business valuation. Here are some examples:
- Valuation is required when selling your business.
- It is also required when you want to sell your “shares.”
- Merging or acquiring your company
- Looking for finances or investors to expand your business
- Establishing partners or ownership
- Required for divorce proceedings
- Required for strategic planning to make better decisions
The valuation of a business depends on your business, market value, industry, and other factors. Small companies are directly sold as asset sales, whereas more significant business involves the sale of equity and sold as middle-marketing transactions. In each sale, it would then require a different business valuation method.
However, small business owners don’t know how to strategize their exit and sell their company at their best value. Most business owners are impatient and don’t realize what their business is worth or how well it will do in the future. Here is a statistical comparison of how Airbnb and Uber increased in value from 2014 to 2018, which bolsters the fact that patience is vital.
Here are some business valuation methods that you need to understand as a business owner before hiring a business evaluation professional.
Valuation Method Through Market Value
Market value approaches compare your company to other companies in the market. For example, in real estate, we examine a house with another to value its worth similar analogy is applied in the valuation of the business. The limitation in this method is that it only works if there are related businesses of the same size in the market, especially in the sole proprietorship.
In the case of seeking an investor or selling your business, this method is purely based on the estimate; hence it is not precise. Moreover, this method might work well when seeking investors. In the end, you will have to negotiate over its value, and you might have to convince your buyer of its worth based on unmeasurable factors.
However, this method is only preferred for a rough estimation or an insight into your business’s value that may help you make a better decision.
The asset-based valuation method helps you evaluate your company’s worth. Since equipment, inventory, and property are all assets; hence this type of plan considers each asset’s value. To simplify it, in your balance sheet, we consider the business’s total net asset minus the total liabilities. However, there are two main methods:
- Going Concern Method: This method should be employed when the company will continue to operate and not sell its assets. This approach is an asset-based evaluation that takes the business’s total equity, which is your assets minus the liabilities.
- Value of Liquidation: In this method, we consider that the business has stopped operating, and all the assets will be liquidated. The company’s amount will then be based on the net cash after terminating the marketing and selling its assets. However, one drawback of this method is that the assets will be valued less than the market value. In a state of urgency, the liquidation method is used to sell a business.
Discounted Cash Flow Valuation Method
Typically, ROI based valuation methods, asset-based valuation methods, and market-based valuation methods are used, but this is also a high estimate to evaluate your business. The DCF method is the income approach as it values the company based on it’s projected cash flow discounted to its present value.
The DCF method is most effective when the business’s revenue is not consistent. However, the DCF method requires complex calculations and extreme detailing.
ROI based Valuation Method
In this method, the business is evaluated based on the return of investment and its profit. For example, pitching your business to a potential investor, and your business is valued at $500,000. You ask 25% in exchange for your business using the ROI method. You will get 2 million ($500,000/0.25).
ROI method is quite practical and gives an insight to the investor on the return on his investment. However, ROI is wholly dependent on the market, which is why these methods are subjective. But there are some factors that the investor will consider such as:
- Is the number ambitious or realistic?
- How long will it take to cover my initial investment?
- Is investing in the company safe?
- What does my return look like after investing in the business?
Capitalization of Earnings and Multiple Earnings Method
Capitalization of earnings method calculates the business profits of the future based on its cash flow, expected value, and annual ROI. Unlike the DCF method, it works perfectly for a business that are stable and has little competition. The formula assumes the costs for a single period and that it will continue in the future. For example, it considers the current value of its capability to be profitable in the future.
Like the capitalization method, it determines its value by the potential of its earning in the future. However, this method assigns a multiplier to the current value to calculate the business’s maximum worth. Multipliers are subjected to change to industry, economic climate, and other factors.
Book Value Valuation Method
By examining your balance sheet, this method estimates the current value of your business. Through this approach, the balance sheet will be used to calculate the equity, which is assets minus liabilities to evaluate your business’ worth. This method will be useful in the case of business having low profits but valuable assets.
Key Steps to Determine the Value of a Small Business
Some critical steps need to be followed to help you with your business valuation planning or exit strategy.
- Organizing the Finances: Financial statements, licenses, deeds, propriety documents, tax filings and returns, and a short overview of your business or personal finances. Getting your finances in order will help you maintain realistic expectations through the evaluation procedures and help make decisions.
- Taking Stock of Your Assets: As mentioned before, equity helps determine your business’s value, and that can only happen if you maintain a detailed report of your asset. There are two types of assets, tangible assets such as real estate property, inventory or stock, equipment, and cash.
And your intangible assets are non-material assets such as patents or copyrights, intellectual property, brand and reputation, and customer loyalty such as subscriber base. Moreover, there are other liabilities to consider.
Liabilities are debts or outstanding credit in the balance sheet. These liabilities can be notes payable, accounts payable, business loans, accrued expenses, and other debts & payables.
However, to convince your investor of your business operation and how you generate revenue, you need to pitch your business. They need to understand your business model and business plan. It will help them evaluate their investment return and how to operate your business once you hand it over to them.
- Understanding Your Valuation: As mentioned earlier, your business valuation depends on what type of business you have, how well your business is doing, and what your assets are. However, there are two crucial factors that you need to calculate, such as the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and SDE (Seller’s Discretionary Earnings).
Both quantities help value the business to its real value for the business owner. The SDE will be calculated, much like your reported income to the IRS. The difference is that EBITDA is used by large business owners, while small business owners use SDE. However, calculating SDE is quite complicated; here’s how you can understand and calculate SDE.
- Researching Your Industry: How well your business is going to do in the future is affected by the industry of your business. Some industries are affected by external factors more than others. And as mentioned earlier, future financial projections help evaluate the worth of your business. Hence it is highly recommended that you do a thorough study on your industry. Consider business owners like yourself and their financial projections.
Studying your industry and businesses like yourself will only help you make a smart decision and value your business on what it’s worth.
Challenges You May Face in Your Exit Strategy
In a survey of 200 San Diego business owners revealed critical insights into some challenges faced in the exit strategy. Here are eight statistics by Exit Planning Institute that explains the scope of these challenges:
- Minimal Planning: 53% of the correspondents told that they had little to no planning even though three-quarters of these business owners were 51 and above.
- Unknown Value: Around 66% of the correspondents revealed that they hoped to get the full value of their business to fund retirement. Less than 40% didn’t have a business valuation conducted in the past three years, and almost 65% never had their finances audited.
- Questions relevant to management: About 33% of the business owners had no idea of the succession of command. However, 25% of the owners were confident that the managerial team would be successful without their owner being involved in the transition.
- Partnership: About 48% of the correspondents have a buy-sell-agreement with their partners.
- Estate Exclusions: 58% of the correspondents responded that they have an estate plan. While 69% met their policy does not include an updated version of business valuation, 65% responded that the business’s sale didn’t include their estate plan.
- Carelessly Lazy About Future Needs: Almost 70% of the correspondents are unaware of the taxation required to support their lifestyle.
- Pursuing it Alone: Around 80% didn’t think they needed a professional business evaluator to help them value their asset.
- No Transition Plan: 88% didn’t have any transition plan.
Here are some business exit strategies you need to understand.
The Bottom Line
The bottom line is that evaluating your business is gut-wrenching and complicated. Hence it’s best to do your thorough research and then hire a professional. Moreover, it is also highly crucial for you to understand the challenges that will occur without an efficient exit strategy method. Why do you need a professional to help you?